Writing China: The Limits of the Yuan’s Global Rise

Eswar Prasad at a discussion on East Asia and the Pacific during the annual World Bank/IMF meetings in the World Bank Headquarters in Washington D.C in 2013, with World Bank Chief Operating Officer and Managing Director Mulyani Indrawati.
Photo:
Agence France-Presse/Getty Images

On Oct. 1, the Chinese yuan will join the International Monetary Fund's basket of elite reserve currencies, a milestone in Beijing's efforts to promote the yuan's global profile.

In his new book, "Gaining Currency," Eswar Prasad, a former top China hand at the IMF, says China needs to carry out a broad range of reforms, both economic and political, before the yuan can become a truly global currency on par with the dollar.

The 51-year-old, who now teaches and does academic research at Cornell University and also thinks big policy thoughts at the Brookings Institution, talks to The Wall Street Journal about the rise of the yuan and the risks that could slow or reverse China’s economic progress and the ascendancy of its currency.

China so far has managed to promote the yuan globally without fully giving up control. How long do you think China can keep using this "unique playbook," as you called it in the book?

It is remarkable that the yuan has become an official reserve currency even without meeting the traditional prerequisites, such as an open capital account and a market-determined exchange rate. China’s sheer size is a key factor, of course. But size goes only so far, and even China cannot fully escape the basic laws of economics. It will be difficult for the yuan to rival other major reserve currencies such as the euro and the Japanese yen unless the capital account becomes fully open, allowing for the free flow of capital in both directions, and the exchange rate is fully freed up.

Some commentators have said the yuan's inclusion in the IMF's basket of reserve currencies, known as Special Drawing Rights, or SDR, could help push forward much-needed financial overhauls in China. Yet progress has been slow since the IMF announced its decision in November, and in some cases, the government appears to have backpedaled on reforms. What do you think has changed?

The check-list of reforms required for the yuan’s inclusion in the IMF’s SDR basket served as an important catalyst for many financial and capital market reforms in China last year. The freeing up of bank deposit rates, the explicit deposit insurance system, and the (ostensibly) greater flexibility of the exchange rate might have been delayed or not implemented at all were it not for the IMF-imposed deadline. However, the stock-market turmoil during last summer and currency-market turmoil during the fall and into the first few months of this year seem to have emboldened reactionary forces within China opposed to such reforms and also given the government cold feet about moving forward too aggressively.

You wrote in the book that the Chinese government has been "quite canny" and its currency policy moves over the years "have suited its own best interests every step of the way." Do you think it's still in Beijing's best interests to continue elevating the yuan's role on the world stage?

The move toward a more market-determined exchange rate allowed China to effectively undercut the U.S. Treasury’s long-standing criticism of its currency policy. But China timed the move to its own advantage—implementing it at a time when the markets were pushing for a depreciation of the yuan. Indeed, in a rich irony, preventing the yuan from depreciating further runs counter to the U.S. Treasury's long-standing calls for China to have a more market-determined exchange rate. The objective of making the yuan a truly global currency still serves the Chinese leadership well. It provides a framework for pushing forward capital-account opening, financial-sector reforms and exchange-rate flexibility, and blunting domestic opposition to those reforms. In the book, I describe this as a “Trojan horse” strategy. Whatever happens with the yuan’s prominence on the world stage, such reforms are good for the Chinese economy.

What would a truly global yuan entail?

China needs a more market-oriented economy that is subject to less government intervention as well as broader, more liquid and better-regulated financial markets. To ascend from a reserve currency to a “safe-haven” currency, China will also need to undertake reforms that engender the trust of foreign investors. This includes a more open and transparent government that is subject to checks and balances, primacy of the rule of law and an independent central bank.

Do you think the Chinese leadership has the resolve to take all the steps you laid out?

While the trajectory of the yuan’s rise is remarkable, the hype about the currency’s inevitable rise to dominance and associated fears about the U.S. dollar’s decline are vastly overblown. The Chinese leadership is pursuing financial liberalization and limited market-oriented economic reforms. But it has forcefully and unequivocally repudiated political, legal, and institutional reforms. China might have rising economic clout but, without these broader reforms, it will never gain the trust of foreign investors.

Since late last year, the Chinese government has repeatedly pledged to press ahead with currency reforms and at the same time, to keep the yuan largely stable. What do you think of these two conflicting goals?

China’s currency regime represents a grand experiment in whether the tension between two fundamentally contradictory impulses—more freedom for market forces but with a heavy dose of government intervention to maintain “stability and order”—can be reconciled. My sense is that the PBOC [People's Bank of China], with the permission of the State Council, would like to free up the exchange rate further so it can manage monetary policy with fewer constraints. However, the currency policy change on August 11, 2015, was implemented and communicated poorly, leading to a capital outflow-currency depreciation problem. This was exacerbated by concerns that the Chinese economy had stalled.

What's your assessment of the central bank's management of the currency regime since August 2015?

The PBOC is doing a better job in terms of communicating its policy objectives to markets. However, markets still perceive a lack of clarity in the PBOC’s intentions. That has left markets guessing about the PBOC’s true goals and policies, which creates a risk of further volatility in currency markets.

What is your favorite part of the book?

Chapter 1. This chapter is mostly about Chinese monetary history, which I find fascinating. It turns out the yuan has been China’s currency only since 1949, when the People’s Republic of China was formed. The chapter also describes why it was only in the fifth series of yuan notes, first issued in 1999, that the iconic full-face image of Mao was plastered on notes of all denominations. The evolution of images on yuan notes parallels interesting historical developments in China.